U.S. Dollar Can Still Make a Comeback Warn Some Analysts

- USD bears turns cautious as U.S. grapples with contested election.
- Dem White House, Rep Senate offer sweet spot for global markets.
- As Biden curbs China tensions, Senate imposes checks & balances.
- Rep Senate keeps tax cuts and constrains climate policy ambitions. 

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The Dollar is the worst performing major currency of the past week as markets buy into 'risk on' assets such as stocks and higher yielding currencies in anticipation of a final confirmation that Democrat nominee Joe Biden has won the U.S. presidential election, although analysts have in some cases warned that the U.S. currency could be in for a comeback as Donald Trump's team launches numerous legal challenges against the result. 

U.S. Dollars were sold while Pounds, Euros and all other Dollars were bought on as investors took a possible Biden victory to the bank after votes closed in Tuesday's poll, although there remained a narrow path to victory for the incumbent President Donald Trump, albeit one that is difficult for the would-be two-time president to access.

Arizona and a handful of other swing states are key to the final outcome, which could yet deliver a Trumpian boost to the Dollar, although even if the currently-consensus scenario of a victory for Democratic Party hopeful Joe Biden is confirmed the outlook for the currency markets is now murkier than many had anticipated.

"We no longer see a compelling narrative of dollar weakness," says George Saravelos, a strategist at Deutsche Bank. "We see the risks as skewed towards a deterioration in COVID outcomes, an absence of fiscal support, persistent institutional uncertainty and broader negative growth surprises in the US in coming weeks. This environment would usually be associated with a weaker currency. The dollar, however, is unique in its behaviour as a safe haven and a counter-cyclical asset: it has weakened over the last six months as equities have rallied and the yield curve has priced reflation. It follows that deflation and risk-aversion, even if originating in the US, could be dollar positive."

Saravelos and the Deutsche Bank team say that bets against the Dollar no longer offer a good enough risk-to-reward balance given the increased prospect of a contested election and likelihood that the impulses and policy agenda of a Democratic Party White House are subject to the checks and balances of a Republican held Senate. 

Above: U.S. Dollar performance against major rivals in week to Thursday. Source: Pound Sterling Live. 

They've abandoned wagers against the Dollar, which had favoured emerging market currencies, and are now doubtful of whether the additional declines they had anticipated will materialise ahead of year-end. 

“Despite what some might say, the vote counting will continue and no matter the victor, one thing is clear – the US remains a deeply divided country," says George Vessey, a currency strategist at Western Union Business Solutions. “A politically divided US means a more challenged domestic economy at a time when a second Covid-19 wave is already disrupting activity across Europe.”

Republicans did look on Thursday as if they were in line to hold the Senate that many had expected them to lose amid a widely anticipated, but not yet materialised 'blue wave' that was seen washing away their one seat majority. 

That likely means lesser hostility in Washington toward China and a related reduction of safe-haven demand for the Dollar, although it also means the Republican Party will be able to impose its zeal for fiscal discipline onto a U.S. government that had been expected spend big in a number of areas.  

"Potential for Biden as President, a smaller Democrat majority in the House of Representatives and a slim Republican majority in the Senate is being taken as a comfortable outcome for markets and one in which risks of excessive fiscal largesse will be contained. Consequently, we have seen a broad bull flattening in bond markets, further lifts in stock markets and firmer risk currencies as USD slips," says Tim Riddell, a London-based strategist at Westpac. 

"Consider that if we do indeed get a President Biden, it would be with a Republican Senate determined to do unto Biden on Ukraine-related issues what the Democratic Senate did unto Trump on Ukraine-related issues, and with less of a House majority now to boot. Forget about fiscal expansion, or much of what Biden promised on the election trail (apart from the Buy American part?)," says Michael Every, a strategist at Rabobank.

The consensus view in the market had been that a large Democrat spending programme would lead to more Federal Reserve (Fed) money creation and resulting declines for the greenback, while the economy was expected to be left grappling with a reversal of President Donald Trump's 2018 tax cuts and regulatory revolution in the name of containing the rate of climate change. But with a Republican held Senate all of these are potentially off the agenda.

This has positive implications for the Dollar, stock markets and the global economy. It's effectively a best-of-both-worlds outcome for investors that leaves global markets in a sweet spot. All of this comes after an early lead for the incumbent on election night was washed away in key states by postal votes coming in from what are widely described as Democrat-leaning areas and at the last minute. The Trump campaign has, citing irregularities, initiated legal challenges and is demanding recounts in a number of states.

"Nothing is certain and it could take a while before we have the official result, especially as Trump has demanded recounts in several states (where Biden only has a narrow lead) and has started legal battles to stop counting in others," says Jeroen Blokland, a multi-asset portfolio manager at Robeco, a fund manager with €181 bn under management in 2019. "For the medium-term, the arrival and effectiveness of a Covid-19 vaccine is a much more important factor for the market outlook."

Meanwhile in Europe, the UK returned to 'lockdown' Thursday, joining France, Germany, Spain and Italy in imposing varying draconian restrictions. The new shutdowns are widely expected to endure at least for the month of November and to extinguish the economic recovery at least in the current quarter. 

Above: Pound-to-Dollar shown at daily intervals alongside EUR/USD (yellow line, left axis).

All necessitated increased spending by already highly indebted governments, which implies further easing - new money creation - by central banks on top of the economic damage. That damage could grow over the coming weeks and months if the shutdowns are extended.

British Chancellor Rishi Sunak extended the government furlough scheme on Thursday so that it runs until the end of March rather than the December 02 date that Downing Street currently claims will be the end of the new enhanced curbs on freedoms and activity. 

"FX appears to be taking its cue from equities more so than rates. The trade-weighted USD is at key support levels here, so I’m not sure equities will have as much gravitas on FX in the near-term. Also, we place more emphasis on the lack of big ticket spending," says Bipan Rai, North American head of FX strategy at CIBC Capital Markets. "A divided government means that we ought to be thinking about the odds of a short USD squeeze." 

The Bank of England (BoE) was the latest to expand its balance sheet on Thursday, having added £150bn to its quantitative easing target, but is unlikely to be the last the European Central Bank (ECB) said explicitly last week that it too will act next month. 

Pound Sterling, the Euro and other European currencies may be the most vulnerable to a Dollar correction over the coming days and weeks given that a Biden presidency will not solve the continent's longstanding economic woes or the UK's Brexit connundrum. 

"The Brexit factor will continue to constrain movement in both directions in the GBP, though it's worth pointing out that mainstream coverage is predicting a Biden win (on balance, that may put a cap on EURGBP). In GBPUSD, the pair should continue to track broad moves in the USD and levels of investor risk appetite over the balance of the week. That said, topside in GBP is more likely to be a slow grind rather than abrupt spike," says Stephen Gallo, European head of FX strategy at BMO Capital Markets.